Sunday, October 19, 2008

Is Morgan Stanley's Stephen Roach the Long Lost Son of Anna J. Schwartz?

I have long been a fan of Stephen Roach who early on called attention to the distortionary policies of the Federal Reserve in the early-to-mid 2000s. His main beefs with the Fed were (1) its failure to acknowledge its own policies were contributing to one of the biggest asset bubbles of all time and (2) its unwillingness to address the asset bubble problem. His frustration with the Fed reached a high with the publication of the now classic "Original Sin" article in 2005 where he wrote the following:

In all my years in this business, never before have I seen a central bank attempt to spin the debate as America’s Federal Reserve has over the past six or seven years. From the New Paradigm mantra of the late 1990s to today’s new theories of the current-account adjustment, the central bank has led the charge in attempting to rewrite conventional macroeconomics and in making an effort to convince market participants of the wisdom of its revisionist theories. The problem is that this recasting of macro is very self-serving. It is a concentrated effort on the part of the Fed to exonerate itself from the Original Sin of failing to address asset bubbles.The result is an ever-deepening moral hazard dilemma that poses grave threats to financial markets.

He recently repeated this view in an interesting interview with Bloomberg's Tom Keene and Ken Prewitt. What is interesting is that this weekend Anna J. Scwhartz, the matriarch of monetary economics, made a rather similar critique of the Greenspan Fed in the Wall Street Journal. Here are the key excerpts:

How did we get into this mess in the first place? As in the 1920s, the current "disturbance" started with a "mania." But manias always have a cause. "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.

"The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses."

The house-price boom began with the very low interest rates in the early years of this decade under former Fed Chairman Alan Greenspan.

"Now, Alan Greenspan has issued an epilogue to his memoir, 'Time of Turbulence,' and it's about what's going on in the credit market," Ms. Schwartz says. "And he says, 'Well, it's true that monetary policy was expansive. But there was nothing that a central bank could do in those circumstances. The market would have been very much displeased, if the Fed had tightened and crushed the boom. They would have felt that it wasn't just the boom in the assets that was being terminated.'" In other words, Mr. Greenspan "absolves himself. There was no way you could really terminate the boom because you'd be doing collateral damage to areas of the economy that you don't really want to damage."

Ms Schwartz adds, gently, "I don't think that that's an adequate kind of response to those who argue that absent accommodative monetary policy, you would not have had this asset-price boom." Policies based on such thinking only lead to a more damaging bust when the mania ends, as they all do. "In general, it's easier for a central bank to be accommodative, to be loose, to be promoting conditions that make everybody feel that things are going well."

I think both Roach and Scwhartz would agree there were other important factors at work in creating this boom-bust cycle. However, given the Fed's monetary superpower status--its ability to shape monetary policies across the globe and create a global liquidity glut--both believe the Fed could have and should have done more to (1) an avoid overly accommodative monetary policy in the early-to-mid 2000s and (2) reign in the housing bubble once it started. (Even if there had been "collateral" damage in popping this asset bubble several years ago, certainly it would not have been any worse than our current situation.) The Fed's failure to do so means it shares some of the blame for what appears to be a looming global recession.

1 comment:

If you're someone who's studied the macroeconomics of Friedrich Hayek, this has been easy stuff to see -- and many of us have been sounding the alarm for years now.

Roger Garrison has written terrific stuff showing how Hayekian economics opens a world of macroeconomic phenomena impossible to see when one wears the blinding goggles of the non-Hayekian macroeconomists.

See, for example, Garrison's _Time and Money_.

And yes, I'm one of those Hayekians who has been writing about this artificial boom cycle for years now.